Published March 17 2005. 2:00am EST
Auction-Rate Securities: Players: Heavier Retail Action Can Offset Strict
Market participants are optimistic that strong retail participation In the tax-exempt auction-rate market may cushion that segment of the auction-rate universe from a drop In corporate demand that may result from a literal Interpretation of the Financial Accounting Standards Board’s Rule 95.
Recently, at least two major auditing firms have reinforced a literal interpretation of FASB 95, which mandates that corporate investors must account for auction-rate securities as investments and not as cash-equivalent securities. That interpretation is fueling concerns about a potential drop in corporate investors’ demand.
According ta FASB 95, which was implemented in 1988, ‘”Cash equivalents are short-term, highly liquid investments” that are “readily convertible to known amounts of cash,” and “so near their maturity that they present insignificant risk of changes in value because of changes in interest rates.”
“Generally, only investments with original maturities” that are “three months or less qualify under that definition,” the rule says. “Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an enterprise with banking operations).” In contrast, investments include short-term or long-term assets that are not as readily convertible into cash.
Auction-rate securities do not fit the short-term investment category. Greg Faucette. partner at Ernst & Young, suggests corporate investors should consider classifying the securities under “current assets” in a line designated “short-term investments and available for sole securities,” accompanied by a footnote explaining the rationale.
Herbert Jacobs, general manager at DEPFA Bank, said If corporate Investors have to re-categorlze the securities, they may consider moving their money Into other securities to bring In a higher yield. That’s because the yield from auction-rate securities may not be enough to compensate them for the drop ln liquidity.
Loan agreements may require some corporate borrowers to maintain minimum levels of liquidity.
Jacobs said, however, that if the corporate investor base declines and “if there’s a problem of oversupply, the market may see a dislocation, but not a catastrophic kind of event” He said that retail investors may be more attractive to the securities because higher yields may result if the corporate investor base shrinks.
The retail investor is nat directly affected by FASB 95, according ta Jacobs.
Joseph Fichera, chief executive officer at New York City-based advisory firm Saber Partners, said, “Markets generally adjust. If one set of investors pull out, other investors may be attracted to the securities because the auctions may produce higher yields in order to replace [outgoing] investors. It doesn’t mean everything will collapse.” He added, however, that it would be less attractive for issuers to sell the securities if rates go up.
im Moncur, deputy controller for Houston, agreed that going forward, “one potential concern is that the corporate buyers who need to show cash on their balance sheet instead of a short-term investment may no longer buy these securities” and “auction rates may get more expensive.”
Between Feb. 28 and March 10, “rates on municipal taxable auctions in general have widened about 20 basis points on average” said Kevin Conery, a strategist at Merrill Lynch & Co.
In contrast, “there has been no discernable change in spreads for tax-exempt paper,” Conery said. “It’s interesting that the taxexempt side of the market is not showing a big reaction”
This may be because the retail investor base makes up more than 25% of the investor base for tax-exempt auction rates, he said. FASB 95 “does not impact retail or individual investors. Because of that, it appears that it is not affecting their investment behavior”
Kenneth Kaufman, managing partner at Northfield, 111.,-based Kaufman, Hall & Associates Inc., said as of yesterday the spread between the seven-day and 35-day tax-exempt auction-rate securities was 20-25 basis points.
“That’s a bit wider than the usual, but tax noise is typical between March 15 and April15, so it’s hard to tell what’s otherwise,” he said. Corporations often cash out of securities at this time of the year to meet tax obligations.
Kaufman said that investor reaction is hard to measure at this point and would be better gauged after April 15. At this point, investor appetite for the seven-day retail security remains strong. According to Kaufman, short-term desks are reporting that behavior among corporate investors for tax-exempt auction-rate securities lies anywhere from “normal to mildly dislocated.” The desks are reporting no “meltdown.”
Moncur said that any significant change in costs may cause the issuer to examine other alternatives. Historically, both Houston’s commercial paper and its auction-rate debt have had “roughly” the same costs, he said. “We will be watching very closely to see how the market reacts to this.”
Houston will compare the rates paid on its auction-rate debt versus the rates paid on its commercial paper. If it is consistently higher, “we’ll consider moving some of our auction-rate debt into commercial paper or variable-rate debt that is not subject to these accounting restrictions,” he said. However, as of Friday, “we have not observed our auction rates costing more than our commercial paper at this time; he added.
Bankers were reluctant to talk about FASB 95 and its potential impact on the auction-rate investor base. “We don’t know what we’re going to tell our clients yet,” one official at an investment bank said. “our bankers, lawyers, and compliance people are trying to wrap their heads around this right now in order to advise clients.”
Officials at Goldman, Sachs & Co., Citigroup Global Markets Inc., and UBS Financial Services Inc. declined to comment. Gail Sussman, managing director at Moody’s Investors Service, said that the reinforcement of FASB 95 will have no adverse impact on the ratings of the securities because Moody’s has already factored in certain risks, including those that would lead to higher interest rates.
She said that as spreads widen, auction rates will rise when compared with variable rate demand obligations. This may accelerate that slow-down in the sale of auction-rate securities that began last year, she added.
AUCTION RATE VOLUME
In 2004, the pace of the volume of auction-rate securities sold slowed down, in part because the Securities and Exchange Commission began conducting inquiries into the auction-rate programs of some broker-dealers.
The inquiries examined whether dealers tried to manipulate the auctions by sharing information about the bids or by putting in their own bids after having knowledge about other bids in order to avoid a failed auction, which would cause issuers to pay larger interest rates. Manipulating the bids can also lower the risk of volatility in the bids received.
Issuance of auction rates in the municipal market jumped to $25.48 billion through 253 issues in 2002, from $12.33 billion through 151 issues in 2001, according to Thomson Financial. That number again skyrocketed in 2003 as issuers sold $41.26 billion through 434 issues. Last year the pace slowed as issuers sold $42.77 billion through 436 issues, according to Thomson.
Conery said that there is no hard data available, but the firm’s “best guesstimate for auction-rate investors across the board” is that public sector entities, such as retirement funds, government agencies, and government authorities, comprise about 1% of the market. Inter-broker dealers comprise 7%, while investment advisers make up 15%. Banks and high-net-worth individuals comprise 15% and 25%, respectively, while corporations, such as insurance, industrial, retail, and high-tech companies, comprise 36%.
Conery said that the corporate investor base could be as low as 30% or as high as more than 50% across the board. For the tax-exempt market, the corporate base is closer to the low end of that range, he added. The retail base exceeds 25%, he said.
The issue of reporting auction rates as cash equivalents was raised in a routine review of the big four accounting firms by the Public Company Accounting Oversight Board, market players said. “Someone had classified these as cash equivalent and the fact that the question was raised heightened the awareness of this issue for this reporting season,” Ernst & Young’s Faucette said.
The PCAOB has routine inspections of auditing firms that result in public reports. During the process, however, inspections are not are not discussed. Every accounting firm that operates in the U.S. and audits more than 100 public companies is inspected annually.
Currently there are about eight auditing firms that are inspected each year. Others are inspected about once every three years. A spokeswoman at the PCAOB said on Friday that the board has not issued any recent verbal or written report about FASB 95.
Merrill’s Conery, in a report published March 4, said: “For years, auditors appeared to abide by the ‘spirit’ of FASB 95 interpretations as they did not challenge those investors that treated auction securities as a cash equivalent. Now they have begun taking a literal interpretation that will result in moving auction-market securities from the cosh equivalent section to the investment section of the balance sheet.”
According to a PriceWaterhouseCoopers report on Feb. 16 entitled “Dateline 2005-05: Investors’ Classification of Auction-Rate Securities: “Some investors have classified [auction-rate] securities as cash equivalents on their balance sheets because the interest rate on the securities is reset periodically in an auction process that occurs at least as often as every three months, resulting in a highly liquid market for such securities. However, this classification likely is not appropriate.” The interest rate on auction-rote securities frequently reset, but auction rates con corry long-term maturities.
Ernst & Young’s Faucette said that frequently resetting the dotes of auction-rate securities wchonges the interest rote, but does not change the maturity date. At E&Y, our consistent position is that these would not be cash equivalent securities: he said.
“An auction can fall and there is no guarantee the company will be able to get its money out on the auction date; Faucette added.